By Alistair Smout, David Milliken and David Lawder

LONDON/RIO DE JANEIRO (Reuters) – Britain’s new finance minister, Rachel Reeves, will set out on Monday the extent of the chaos in public finances she says she inherited, potentially paving the way for tax rises that critics say she could have been more open about before the election.

Following Labour’s election victory on 4 July, Reeves ordered an assessment of public spending needs that were not fully captured in the official budget forecasts published in March.

Reeves has repeatedly said that the winner of the election will inherit the worst economic situation since World War II, but ruled out raising tax rates on almost all major taxes to solve the problem.

Labour sources said on Friday that Reeves was now expected to uncover a £20 billion ($26 billion) hole in the state’s finances.

The Office for Budget Responsibility, Britain’s independent fiscal watchdog, said in March that the previous Conservative government’s five-year budget plans left just £8.9 billion of room to meet a self-imposed rule designed to prevent debt from rising.

Reeves has said that while she would rather cut taxes than raise them, she would not make any promises she could not keep on the debt rules that Labour has committed to uphold.

Reeves expected her assessment of finances to be criticized, telling reporters at a meeting of G20 finance leaders in Brazil late Thursday that she had spoken openly about the need to overhaul the public service and stop the rise in debt.

“We inherited a mess,” she said. “I have always been honest that the scale of the challenge facing this new government is immense because of the damage the Conservatives have done to the economy and public services.”

Before her speech to Parliament, Reeves declined to comment on whether the hole was £20 billion or how exactly she intends to cover it.

The Conservatives immediately criticised the £20 billion figure, calling it a prelude to unnecessary tax increases.

“The Labour Party’s claims are nothing but fabrication. The books have been completely open since the OBR was founded 14 years ago,” said former Conservative Chancellor of the Exchequer Jeremy Hunt.

POLITICAL EXERCISE

New Prime Minister Keir Starmer said on Wednesday after 14 years of Conservative government: “We have a worse crisis than we thought when we looked at the books.” Ministers said the crisis has an impact on everything from prisons to immigration and health.

But economists and analysts said that while a Treasury review of spending needs could mitigate the political impact of the tax rises, there were no major economic surprises that Labour could not have foreseen.

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Reeves himself told the Financial Times in June that Labour did not have to win an election to learn about the poor state of public finances.

The Labour Party’s manifesto included small tax increases to finance certain commitments, but other than a general commitment to increase funding through stronger growth, further budgetary details were sparse.

Neither major party outlined how it would address the projected health funding shortfalls, and Labour accepted Conservative budget plans to cut spending on some public services, which analysts had said were unsustainable.

Ben Zaranko, senior economic researcher at the nonpartisan think tank Institute for Fiscal Studies, said Reeves’ statement was “a political exercise and not a serious response to new information.”

“I think the fiscal challenge that awaits this administration has been obvious to anyone who has bothered to look closely… Maybe some of the details are a surprise, but the overall trend has been clear,” he said. “Neither party has been completely open about the challenge.”

RED LINES

The budget situation is somewhat worse in some areas than the Labour Party expected.

Borrowing in the three months to the end of June was £3.2 billion above the OBR forecast in March.

At 99.5 percent of GDP, national debt is higher than it has been since the early 1960s, 0.8 percentage points more than forecast. And the tax burden is already higher than it has been since the late 1940s.

Reeves has also indicated that she will accept the recommendation for a public sector pay increase, which provides a higher-than-expected 5.5 percent increase for teachers and health workers.

She is expected to announce the pay rise on Monday, along with the date of the next budget.

Pantheon Macroeconomics said such a pay rise would use up almost all of the fiscal space left after Hunt’s March budget.

“In addition, we assume that the budget situation has worsened since (March),” it said.

The Labour Party has ruled out increases in income tax, national insurance contributions, VAT and corporation tax, thereby tying its hands in terms of tax revenue in the future.

Former Bank of England policymaker Michael Saunders, now senior economic adviser at Oxford Economics, said the government could raise taxes by £10-25 billion and would likely focus on inheritance or capital gains tax to avoid breaching election promises.

While Labour may be able to keep its promise not to raise certain income tax rates this year, the IFS’s Zaranko warned that the party would come under increasing pressure if the government failed to deliver the growth it wanted.

“Perhaps at some point they will be forced to reconsider these red lines,” he said. “The longer the Parliament exists, the more difficult it will be, in my opinion.”

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(Reporting by Alistair Smout and David Milliken in London and David Lawder in Rio de Janeiro; editing by Toby Chopra)